Investors tend to buy bonds to seek shelter from market volatility and fluctuating prices, right? Surely, bonds can't change in price by 50%, 60%, or even 70% in a year. However, this extreme bond volatility is possible, and is why I recommend understanding two key points before investing in bonds. These two topics are the inverse relationship bond prices have with interest rates and how duration impacts expected price movements.
Inverse Relationship
Bonds held until maturity will return the originally agreed-upon interest rate and principal (assuming they don't default). However, if you want to sell the bond before maturity, this relationship will impact your sale price. This is because when interest rates increase, bond prices tend to decrease. And when interest rates decline, bond prices tend to grow. As seen in the chart below. As we move further to the right, interest rates decline and the total return of the bond rises.
Duration
Is how long it takes for a bond to mature. The shorter a bond's duration, the less volatile its price will be during a changing interest rate environment. And the longer its duration, the more volatile its price will be when rates change. You can see this in the chart above. Even large percentage swings of 3%/300bps up or down only change the 3-year treasury bond by -0.6% on the low end and +10.6% on the high end. However, if we go to a 30-year treasury bond, the range grows to -31% and +75.7% for the same interest rate movement!
Recommendation
Although these lessons are simple on paper, things tend to work differently when the rubber meets the road. Interest rate movement and timing is notoriously hard to predict. Rates could move three years after you thought they would move and in the opposite direction than you expected! At that point, your duration has changed which impacts your expected volatility. As enticing as that 75% return block on the chart is, I am not recommending speculating on long-duration bonds in the hopes of a 3% drop in the market so you can receive a significant return. Despite how many real estate agents swear rates are going down in the next few months. I recommend investing in a portfolio that suits your time horizon, risk tolerance, and return requirements. If receiving a 4.5% coupon payment over 10, 20, or 30 years fits into a piece of your financial plan, then it may be a good option for you. But at least now you know why the bond value is changing if you find yourself in a fluctuating interest rate environment. Thanks for reading, and as always, please speak with a financial adviser if you need clarification on any investing or tax decisions.
P.S.
You can listen to a few professionals dig deeper into this topic in this 33-minute podcast.
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